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Value is Elusive

In The Value Project (see the links below), I set out to try to ascertain where and how value in the markets may be found. I argued that establishing a well-diversified asset allocation plan consistent with one’s goals, investment horizon, and risk tolerance should be the first priority. The key advantages of broad and deep diversification are the capture of a healthy share of available returns, smoother portfolio performance and lower volatility. Especially in a secular bear market like the one we have been suffering through since 2000, those are worthy goals.

Once an asset allocation decision is made, one can move on to investment choices to “populate” the plan. On account of the relative success of passive management strategies and the relative failure of active ones, I noted that any recommendation containing active management must be carefully considered and supported, especially when the advisor is a fiduciary. I generally suggest using active investment vehicles within portfolios for momentum strategies, focused (concentrated) investments, in the value and small cap sectors (domestic and international), for low volatility/low beta stocks, and for certain alternative investments. Passive strategies can be used to fill out the portfolio to provide broad and deep diversification.

I carefully emphasized, however, that success in this arena is extremely hard to achieve and success achieved through good asset allocation can be given back quickly via poor active management. Moreover, one cannot count on the suggested active strategies in the short-term, and perhaps not even in the long run (remember, investment success draws a crowd and dilutes future success), but they are excellent potential sources of value (apologies for the pun) today. I focus much of my portfolio attention there.

However, finding investment skill is at least as difficult as finding value, particularly since investing is a probabilistic exercise and, as a consequence, very skilled investors can underperform for significant periods of time. The key then is to choose money managers with more than just a good track record of results. We must choose money managers with an excellent investment process too.

Finally, costs, taxes and fund size matter — a lot. Accordingly, all else being equal, I will generally favor smaller money managers and those who charge lower fees. I will also favor strategies with a higher likelihood of tax efficiency (in taxable accounts), for the same general reasons.

That this framework makes sense has been highlighted in the news recently. The 2012 Quantitative Analysis of Investor Behavior from DALBAR has recently been released and, as always, it reflects comprehensive investor irrationality. In general, investors do not remain invested for sufficiently long periods to derive real benefit from the investment markets and investors make such investment moves at particularly inopportune times. Not surprisingly, investors are particularly bad at market timing — they buy when the market is high and sell when it is low.

For 2011, the QAIB showed that equity investors lost 5.73 percent as compared to the S&P 500’s gain (with dividends) of 2.12 percent. Over 20 years, the average equity investor earned 3.49 percent per year compared to the S&P’s 7.81 percent — an annual underperformance of a whopping 4.32 percent. It seems clear that investors are not finding value and need help. What is less clear is how they can get it. Professional managers (more here) and even hedge funds do not have great track records either.

As The Capital Speculator pointed out yesterday (consistent with my findings in The Value Project), the evidence in favor of passive management (most typically indexing) is surprisingly compelling. TCS correctly concludes that chasing alpha demands a lot of extra time and effort for an uncertain payoff. It’s easy to claim that “market returns” are inadequate (for example, The Reformed Broker does so here), but astonishingly few (including even the always entertaining and frequently insightful Josh) provide reason to think that they can do any better. Again — investors need help but it remains uncertain if and how they can get it.

I offer some suggestions about finding such elusive value in the links below. Happy hunting.